Expanding the pool of potential buyers has reached the upper limit

There are two ways to expand the pool of qualified home buyers, and they both rely on expanding leverage: A) lower the down payment from 20% cash to 3%, and B) lower the mortgage rate to 3.5%.

Lowering the down payment increases the leverage from 4-to-1 to 33-to-1, a massive leap.

Increasing leverage increases risk. Over 90% of all mortgages are guaranteed or backed by Federal agencies such as FHA. This “socialization” of the mortgage industry means that losses ultimately flow through to the taxpayers, who are subsidizing the housing industry via these agencies.

Lowering the mortgage rate increases the leverage of income. It now takes much less income to qualify for greatly reduced monthly payments.

With mortgage rates barely above the prime rate and Treasury bond yields negative in terms of inflation, there is simply no room left for lower rates or down payments. The “increase home sales by expanding the pool of buyers” game plan has been run to the absolute limit.

The pool of buyers cannot be expanded any further; that boost to sales is done.

The unintended consequence of enticing marginal buyers to buy homes is that defaults are rising: 1 out of 6 FHA-insured loans are delinquent. This is the “blowback” of qualifying everyone with an income above the poverty line as a homebuyer.

The mortgage industry has escaped any consequences of “robo-signing” mortgage fraud

If the rule of law existed in more than name, this is what should have happened:

MERS, the mortgage industry's placeholder of fictitious mortgage notes, would have been summarily shut down.

All mortgages and derivatives based on mortgages would have been marked-to-market.

All losses would be booked immediately, and any institution that was deemed insolvent would have been shuttered and its assets auctioned off in an orderly fashion.

Regardless of the cost to owners of mortgages, every deed, lien, and note would be painstakingly reconstructed on every mortgage in the U.S., and the deed and note properly filed in each county as per U.S. law.

That none of this has happened is proof that the rule of law is “optional” for financial institutions in America.

The $25 billion mortgage fraud settlement turned a blind eye to the fraud, and now the banks are applying losses they have already booked to the $25 billion, mooting the supposed “benefit” of the settlement to consumers.

The Federal Reserve’s purchase of mortgages – over $1.1 trillion in 2009-10 and now another $40 billion a month – is essentially a money-laundering operation in which the Fed exchanges cash for dodgy mortgages.

"Thousands of mortgages on homes that do not exist or on homes that have more than one ‘first’ mortgage are now going to the Fed to disappear. Thousands of multifamily and commercial mortgages will be bought up as well. With documents shredded, criminal liabilities extinguished and financial institutions made whole, funds can return without fear of seizure.

QE3 proves beyond any shadow of a doubt that the extent of the fraud was as bad as I said it was. You can count up the bailouts and QE1, QE2, QE3 the numbers speak for themselves. The fraud was indeed in the many trillions of dollars.”

In other words, the financial sector has gotten away with murder, and the “overhang” of systemic fraud has been erased with Fed connivance.

Banks are restricting inventory

The banks are withholding distressed properties to restrict the inventory of homes for sale.

If supply overwhelms demand, prices decline. That would be a bad thing for banks sitting on millions of defaulted mortgages and distressed properties. Millions of impaired properties are being held off the market so supply is lower than demand.

The strategy has costs. Thousands of defaulted homeowners have been living mortgage-free for years. But the gains have been impressive. With supply dwindling, beaten-down markets have seen gains of 20+% this year as strong investor demand has pushed prices higher.

Since the strategy has paid such handsome returns, why change it?

ZIRP has attracted investment

The Fed’s ZIRP (zero interest rate policy) has pushed investors into a “search for safe yield” that has led many to buy corporate bonds, dividend stocks and everyone’s favorite “safe” fixed asset, real estate.

In many markets, one-third or more of all sales have been to investors.

Some are buying distressed properties to “flip” in strong-demand markets, but many are buying the homes as rentals with the plan being to hold them for a few years as prices rise and then sell to reap appreciation.

Anecdotally, every investor class is getting into the act, from Mom and Pop to big players such as insurance companies and Wall Street funds. One of my contacts in the insurance industry told me that his firm was buying large multi-unit apartment complexes, as these rentals generated a yield of 6% to 7%, far above the 1.7% yield of ten-year Treasury bonds.

In a non-ZIRP world, Treasuries and other asset classes would offer similar yields but without the risks and costs of managing rentals. But in a ZIRP world of near-zero yields for low-risk financial assets, rental real estate is a compelling investment: decent yields, relatively low risk, and strong appreciation potential if housing has indeed bottomed.

“The bottom is in” – isn't it?

Once potential buyers see prices rise and they conclude that “the bottom is in,” they jump in and buy, pushing prices higher in a positive feedback loop. The higher prices rise, the more evidence there is that the bottom is in, and the greater the incentives to jump in before prices once again rise out of reach.

Favorable rent/buy ratio

With mortgage rates well below 4%, the rent-buy ratio is favorable in many areas. It may indeed be cheaper to buy than to rent in some locales.

“Hot money” flowing into real-estate

As economies in Europe and Asia falter, “hot money” is flowing into perceived “safe havens” such as the U.S. and Canada. Some of this “hot money” ($225-$300 billion a year is leaving China alone) is flowing into real estate, a well-known phenomenon in markets such as Vancouver, B.C., Miami, and Los Angeles.

Conclusion

What can we conclude from this overview of fundamentals?

The mortgage industry escaped any real consequence from its systemic fraud

The Status Quo plan to reflate the housing market with super-low mortgage rates and down payments has worked to some degree

The financial sector’s plan to boost home prices by limiting supply has also worked

ZIRP has created a “crowded trade” in low-risk investments with attractive yields such as corporate bonds, dividend stocks, and real estate, which is being fueled by a self-reinforcing perception that “the bottom is in”

The question now is will these forces continue pushing prices higher? If so, the bottom may well be in. If these forces deteriorate or lose their effectiveness, then the “green shoots” of investor interest may wither as the U.S. economy joins Europe and Japan by re-entering recession.

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7 Comments

a competing factor is the house prices now are lower than the cost to rebuild them. inflationary pressure on materials will make this disparity increase. so in the very long term, it seems like real estate would be a good "commodity" investment.

Citi's Global Head of Credit Strategy, Matt King, has a knack for putting together useful illustrations.

The slide presented below is particularly striking. King explained it to us like this:

"It's what I like to call "the most depressing slide I've ever created." In almost every country you look at, the peak in real estate prices has coincided – give or take literally a couple of years – with the peak in the inverse dependency ratio (the proportion of population of working age relative to old and young).

In the past, we all levered up, bought a big house, enjoyed capital gains tax-free, lived in the thing, and then, when the kids grew up and left home, we sold it to someone in our children's generation. Unfortunately, that doesn't work so well when there start to be more pensioners than workers."

Citi's Global Head of Credit Strategy, Matt King, has a knack for putting together useful illustrations.

The slide presented below is particularly striking. King explained it to us like this:

"It's what I like to call "the most depressing slide I've ever created." In almost every country you look at, the peak in real estate prices has coincided – give or take literally a couple of years – with the peak in the inverse dependency ratio (the proportion of population of working age relative to old and young).

In the past, we all levered up, bought a big house, enjoyed capital gains tax-free, lived in the thing, and then, when the kids grew up and left home, we sold it to someone in our children's generation. Unfortunately, that doesn't work so well when there start to be more pensioners than workers."

Is it a modest sized one that Generation Y can afford, or is it a 4,000+ sq.ft. McMansion that some boomers "upgrade" to later in life, but may never end up owning? I suspect the former will hold their value much better than the latter in the coming years, especially as energy costs inevitably rise. Apart from that, we often forget that "housing as an investment" is a historically recent phenomenon -- prior to 1960 a house was just a place you lived in and the price didn't go up much other than matching inflation. Maybe we are getting back to those days.

Just watched David Lichtenstein on Bloomberg, and he convinced me that there is plenty of space for investing in real estate. As with any investment, stocks, bonds and buying and selling real estate, there is a risk that the value of the investment will go up and down, but the bottom line is, as David Lichtenstein explains, real estate values have and always will appreciate.